The year so far is shaping up to be quite challenging with key equity benchmarks down around 20% for the first half, and even worse for the tech-heavy Nasdaq.
We have been buying more of the companies we already own during the June quarter and with perfect hindsight we could have delayed some of this purchase activity, especially given our emphasis on patience at the start of the year. As we wrote in our fourth quarter 2021 letter to investors:
In this scenario patience will be required. Any downturn in equity markets may not be the standard ‘buy the dip’ opportunity of the past decade. A 15% decline in markets could easily be followed by further interest rate increases, and a further 15% decline in equity prices.
Nevertheless, we still retain some dry powder to deploy. With any luck prices will continue to go lower and some truly exciting long-term investment opportunities will arise. Not that we are counting on it. We are already finding a growing list of terrific businesses being offered at quite reasonable prices. A strategy of waiting for outright bargains could get lucky, but is not something we are banking on.
The biggest obstacle in this endeavor is perhaps that the bear case for equities is too easy to see. Is anyone really unaware, at this point, that a recession is now likely?
Central banks around the world, with the exception perhaps of the Bank of Japan, are committed to raising short-term interest rates to combat inflation—asset prices be d*#$%d. This was a scenario we worried about going all the way back to 2019; a time when we admittedly came across as tinfoil hat-wearing fruitcakes. We worried that inflation was the one element that could derail a decade-long bull market in equities and especially growth stocks.
Then in August of last year (has it really been that long since we last posted on this blog?) we flagged that inflation was likely to remain persistent throughout 2022. With the year halfway through, so far that has been the correct call. The US CPI figure for June showed headline inflation up 9.1% y/y and the core CPI (excluding food and energy) up 0.7% month-on-month, accelerating from May and well above estimates. You have to pinch yourself as you read those figures to remember just how extraordinary they are. Certainly this is way above what anyone would have believed a year ago.
We don’t have a crystal ball for forecasting macroeconomics and certainly had no idea that Russia would invade Ukraine. Far from it. In 2019 we simply noted a growing consensus among economists and policymakers that both fiscal and monetary policy levers would be needed to respond to a future downturn and that combination had the potential to create higher prices, especially if fiscal policy directed its largesse into the hands of consumers.
By mid-2021 we paid attention to the excellent work by the economists at US mortgage agency, Fannie Mae, who noted the lagged relationship between rising rents and house prices on the shelter component of inflation. Based on the data they had to hand in mid-2021 the economists at Fannie Mae concluded that shelter inflation would likely be contributing over 2 percentage points to the core CPI figure by around now. Given the strength of those relationships, it’s not surprising at all that they were right. The more important question is, Fannie Mae saw it coming, why weren’t monetary policymakers paying more attention?
June’s shelter inflation was up 0.6% month-on-month for the second month in a row, and up 5.6% y/y. With a weighting of 40% in the core CPI basket, shelter contributed around 2.2 percentage points of total core inflation of 5.9%. The shelter component is slow moving and quite sticky, so even as home price rises ease and rental vacancy rates pick up, shelter inflation is unlikely to go into sharp reverse as could occur with other elements of inflation, such as used car and truck prices, or even gas prices. That said, given that vacancy rates are easing and US existing home sales are turning lower, some of the pressure on shelter inflation should slowly start to ease.
So this is our dilemma: the bear case for equities is easy to see and as of mid-June, almost universally accepted. Investor sentiment has become overwhelmingly negative. The American Association of Individual Investors (AAII) Sentiment Survey as of mid-June had just 18% of investors bullish and 59% bearish, versus a long-term average of 38% bullish and 31% bearish, i.e. the number of bears is double normal levels. Professional investors are even more depressed. According to Bank of America’s fund manager survey in early June, 73% of managers were pessimistic about global growth, the highest since the survey began in 1994! A recent survey by CNBC had 52% of participants expecting the economy to be worse next year—the worst outlook measures in the survey’s 15-year history. Six out of ten expected a recession within the next year.
These are fairly dismal readings. The economists, whose unenviable task it is to predict the unknowable path of the economy, have switched to near ubiquitous despondency. And any mainstream economist that doesn’t have stagflation as their base case now sounds Pollyanish (not forgetting it was those same mainstream economists that laughed at the idea of persistently high inflation a year ago). Such comfortable negativity and widespread fear of even steeper losses does tend to drive movements in the opposite direction, at least in the near term. That may partly explain the small bounce we have already seen in early July.
Someone once said to be greedy when others are fearful, but there is no single, reliable indicator of maximum fear. Survey figures as poor as those quoted above are probably about as good one can expect in that respect, although it’s not quite as clear whether that has yet translated into maximum revulsion of equities.
Investors are in a funk, which has led us to buying more shares. If investors get really bummed out, throw their stocks in the trash and go off to do other things, we will be there to greedily rummage through the refuse.
Our goal here at Phronimos is to identify a handful of great businesses from around the world that are enduring, resilient and that can grow their revenues and earnings at attractive rates for decades to come. We aim to acquire those businesses at reasonable or attractive prices and hold them for the long-term, preferably many, many years. A great businesses offered for sale at a reasonable price isn't something that happens every day, but when investors are nursing recent losses and worried about the future, your chances improve. When those opportunities do arise it makes sense to invest a meaningful amount and at other times do nothing.
We aim to own great businesses in significant size. This means we will hold a relatively concentrated portfolio, we will not actively trade in and out of stocks, and we won’t make decisions based on unknowable macroeconomic factors or short-term market forecasts. We can’t predict the economy or the market and we don’t intend to try.
We believe this to be the best way to achieve high compound rates of return over the long-term, but it is an approach that may not be for everyone. A concentrated portfolio will likely entail greater volatility than the overall market and there may be extended periods when it appears we are doing very little. When that happens, be sure we are working very hard to do nothing.